Italy expected to pass crucial bond auction test

FRANKFURT Italy is expected to succeed in selling bonds on Thursday in a crucial test of its ability to continue funding itself from the markets. But a smooth sale would not remove longer-term worries over its financial health.

The Italian Treasury is due to hold four auctions of fixed-rate bonds on the day, aiming to borrow between 3 billion and 5 billion euros.

Success of the auctions is crucial not only for Italy, which wants to demonstrate it is not in danger of losing market access as Greece, Ireland and Portugal did, but also for the stability of markets around the euro zone.

Italy's sovereign bond market, the world's third largest, went into near-meltdown on Tuesday as worry about the country's debt burden and its commitment to budget austerity briefly pushed the 10-year yield above 6.0 percent for the first time since the launch of the euro in 1999.

Thursday's bond sale "is the first proper test Italy is going to face after the sudden deterioration since the end of last week," said RBS economist Silvio Peruzzo.

"I think if the auction goes well it doesn't really change the big picture, but if the auction goes badly it could be a disaster."

Bond traders said the Italian Treasury had been contacting banks and other financial institutions in the last few days to reach an understanding on demand for its debt.

"The Treasury have been approaching brokers collecting book orders and the general feeling is that the auction is going to go through," said one trader at a London-based bank, who requested anonymity because of the sensitivity of the issue.

"There is a domestic component but also the international brokers will support the auctions." About half of Italian sovereign debt is held by domestic investors, giving it a solid base of local demand; Italian banks rely on their government's bonds as collateral in money market operations.

Thursday's auctions will offer bonds with about five, six, 12 and 15 years to maturity. Some investors may buy the new debt while offsetting this with further sales of Italian bonds of similar maturities which they already hold, traders said.

In addition, the Italian Treasury typically gives primary dealers which participate in debt sales a discount to ensure their interest. It has scope to adjust this discount if it feels demand is flagging.

DEMAND

The size of Thursday's bond sale is smaller than many traders had expected, which may be due to a desire by the Treasury to limit the risk in the auctions.

On June 28, Italy sold 7.9 billion euros of bonds including 3 billion euros of 10-year debt; demand for that maturity totaled 1.33 times the amount sold, down from 1.50 times at a similar sale in May. Bid-to-cover ratios of at least 1.3 at Thursday's sale might be viewed with relief by the markets.

Sentiment at the auctions is likely to be helped by the agreement of Italy's center-left opposition to smooth the passage through parliament of a four-year, 40 billion euro austerity package. Economy Minister Giulio Tremonti, brushing aside rumors that he might step down, said on Wednesday that the package would be approved by Friday.

Passage is unlikely to reassure markets entirely, however. Although the 10-year bond yield has come well off its peak, it closed Wednesday at 5.57 percent, well above the sub-5 percent levels which prevailed until last week. A senior Italian central bank official said current yield levels could have a considerable impact on Italy's finances if they persisted.

Worse, the European Union has still not managed to agree on a new bailout plan for Greece. As long as Greece's fate remains unresolved, worries about the market impact of a Greek default on other weak euro zone states and the European banking system, and resulting damage to Italy, will remain.

There has been some market speculation that the European Central Bank might reactivate its program of buying government bonds from the secondary market to ensure a smooth Italian auction. But there is no evidence of this and many senior ECB policymakers are known to dislike the controversial program.

"If that were to happen I think the ECB would be extremely clear and make some form of official communication, especially if you are going to step into a market as large as the Italian one."

According to current market estimates, Italy still needs to raise about 175 billion euros in all forms of debt, including medium- and long-term bonds, short-term bills and foreign currency loans, to fund itself this year.

(Editing by Andrew Torchia)

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